1. Frank Cowell: Consumer Optimisation CONSUMER OPTIMISATION MICROECONOMICS Principles and Analysis Frank Cowell July 2015 1 Almost essential Firm: Optimisation Consumption: Basics Almost essential Firm: Optimisation Consumption: Basics Prerequisites Note: the detail in slides marked “ * ” can only be seen if you run the slideshow

2. Frank Cowell: Consumer Optimisation What we’re going to do:  We’ll solve the consumer's optimisation problem using methods that we've already introduced  This enables us to re-cycle old techniques and results  A tip: check the notes / presentation for firm optimisation look for the points of comparison try to find as many reinterpretations as possible July 2015 2

3. Frank Cowell: Consumer Optimisation The problem  Maximise consumer’s utility U(x)U(x) July 2015 3 U assumed to satisfy the standard “shape” axioms  Subject to feasibility constraint x Xx X  and to the budget constraint n  p i x i ≤ y i=1 Assume consumption set X is the non-negative orthant The version with fixed money income

4. Frank Cowell: Consumer Optimisation Overview July 2015 4 Primal and Dual problems Lessons from the Firm Primal and Dual again Consumer: Optimisation Two fundamental views of consumer optimisation

5. Frank Cowell: Consumer Optimisation An obvious approach?  We now have the elements of a standard constrained optimisation problem: the constraints on the consumer the objective function  The next steps might seem obvious: set up a standard Lagrangian solve it interpret the solution  But the obvious approach is not always the most insightful  We’re going to try something a little sneakier… July 2015 5

6. Frank Cowell: Consumer Optimisation Think laterally…  In microeconomics an optimisation problem can often be represented in more than one form  Which form you use depends on the information you want to get from the solution  This applies here  The same consumer optimisation problem can be seen in two different ways  I’ve used the labels “primal” and “dual” that have become standard in the literature July 2015 6

7. Frank Cowell: Consumer Optimisation A five-point plan  Set out the basic consumer optimisation problem the primal problem  Show that the solution is equivalent to another problem the dual problem  Show that this equivalent problem is identical to that of the firm  Write down the solution copy directly from the solution to the firm’s problem  Go back to the problem we first thought of… the primal problem again July 2015 7

8. Frank Cowell: Consumer Optimisation The primal problem July 2015 8 x1x1 x2x2 x*  But there's another way of looking at this  The consumer aims to maximise utility…  Subject to budget constraint max U(x) subject to n  p i x i  y i=1  Defines the primal problem  Solution to primal problem Constraint set increasing preference Contours of objective function

9. Frank Cowell: Consumer Optimisation  *The dual problem 9 x*  Alternatively the consumer could aim to minimise cost…  Subject to utility constraint  Defines the dual problem  Solution to the problem minimise n  pixi pixi i=1 subject to U(x)   Constraint set Reducing cost  Cost minimisation by the firm  But where have we seen the dual problem before? x2x2 x1x1 z1z1 z2z2 z* Reducing cost q July 2015

10. Frank Cowell: Consumer Optimisation Two types of cost minimisation  The similarity between the two problems is not just a curiosity  We can use it to save ourselves work  All the results that we had for the firm's “stage 1” problem can be used  We just need to “translate” them intelligently Swap over the symbols Swap over the terminology Relabel the theorems July 2015 10

11. Frank Cowell: Consumer Optimisation Overview July 2015 11 Primal and Dual problems Lessons from the Firm Primal and Dual again Consumer: Optimisation Reusing results on optimisation

12. Frank Cowell: Consumer Optimisation A lesson from the firm July 2015 12 z1z1 z2z2 z* q x1x1 x2x2 x*   Compare cost-minimisation for the firm…  …and for the consumer  The difference is only in notation  So their solution functions and response functions must be the same Run through formal stuff

13. Frank Cowell: Consumer Optimisation   U(x)  U(x) + λ[  – U(x)] Cost-minimisation: strictly quasiconcave U July 2015 13    U 1 (x  ) = p 1  U 2 (x  ) = p 2 … … …  U n (x  ) = p n  = U(x  ) one for each good n  p i x i i=1  Use the objective function  …and output constraint  …to build the Lagrangian  Minimise  Differentiate w.r.t. x 1, …, x n and set equal to 0  Because of strict quasiconcavity we have an interior solution utility constraint utility constraint  … and w.r.t Lagrange multiplier       A set of n+1 First-Order Conditions  Denote cost minimising values with a *

14. Frank Cowell: Consumer Optimisation If ICs can touch the axes… July 2015 14 n  p i x i i=1 + [  – U(x )]  Minimise Can get “<” if optimal value of this good is 0 Interpretation  A set of n+1 First-Order Conditions    U 1 (x  )  p 1  U 2 (x  )  p 2 … … …  U n (x  )  p n  = U(x  )  Now there is the possibility of corner solutions

15. Frank Cowell: Consumer Optimisation From the FOC July 2015 15 U i (x  ) p i ——— = — U j (x  ) p j  MRS = price ratio  “implicit” price = market price  If both goods i and j are purchased and MRS is defined then… U i (x  ) p i ———  — U j (x  ) p j  If good i could be zero then…  MRS ji  price ratio  “implicit” price  market price Solution

16. Frank Cowell: Consumer Optimisation The solution…  Solving the FOC, you get a cost-minimising value for each good… x i * = H i (p,  )  …for the Lagrange multiplier * = *(p,  )  …and for the minimised value of cost itself  The consumer’s cost function or expenditure function is defined as C(p,  ) := min  p i x i {U(x)  } July 2015 16 vector of goods prices vector of goods prices Specified utility level

17. Frank Cowell: Consumer Optimisation The cost function has the same properties as for the firm  Non-decreasing in every price, increasing in at least one price  Increasing in utility   Concave in p  Homogeneous of degree 1 in all prices p  Shephard's lemma July 2015 17

18. Frank Cowell: Consumer Optimisation Other results follow July 2015 18  Shephard's Lemma gives demand as a function of prices and utility  H i (p,  ) = C i (p,  ) H is the “compensated” or conditional demand function  Properties of the solution function determine behaviour of response functions Downward-sloping with respect to its own price, etc…  “Short-run” results can be used to model side constraints For example rationing

19. Frank Cowell: Consumer Optimisation Comparing firm and consumer July 2015 19 n min  p i x i x i=1 + [  – U(x )]  Cost-minimisation by the firm…  …and expenditure-minimisation by the consumer  …are effectively identical problems  So the solution and response functions are the same: x i * = H i (p,  ) C(p,  ) m min  w i z i z i=1 + [ q –  ( z)]  Solution function: C(w, q) z i * = H i (w, q)  Response function:  Problem: Firm Consumer

20. Frank Cowell: Consumer Optimisation Overview July 2015 20 Primal and Dual problems Lessons from the Firm Primal and Dual again Consumer: Optimisation Exploiting the two approaches

21. Frank Cowell: Consumer Optimisation n U(x) +  [ y –  p i x i ] i=1 The Primal and the Dual… July 2015 21  There’s an attractive symmetry about the two approaches to the problem  …constraint in the primal becomes objective in the dual…  …and vice versa  In both cases the ps are given and you choose the xs But… n  p i x i +  [  – U(x)] i=1

22. Frank Cowell: Consumer Optimisation A neat connection July 2015 22 x1x1 x2x2 x*   Compare the primal problem of the consumer…  …with the dual problem  The two are equivalent  So we can link up their solution functions and response functions Run through the primal x1x1 x2x2 x*

23. Frank Cowell: Consumer Optimisation U(x)U(x) Utility maximisation July 2015 23   U 1 (x  ) =  p 1 U 2 (x  ) =  p 2 … … … U n (x  ) =  p n one for each good  Use the objective function  …and budget constraint  …to build the Lagrangian  Maximise  Differentiate w.r.t. x 1, …, x n and set equal to 0 budget constraint budget constraint  … and w.r.t        A set of n+1 First-Order Conditions  Denote utility maximising values with a * n y   p i x i i=1 n y =  p i x i i=1  If U is strictly quasiconcave we have an interior solution Interpretation If U not strictly quasiconcave then replace “=” by “  ” n + μ [ y –  p i x i ] i=1 Lagrange multiplier

24. Frank Cowell: Consumer Optimisation From the FOC July 2015 24 U i (x  ) p i ——— = — U j (x  ) p j  MRS = price ratio  “implicit” price = market price  If both goods i and j are purchased and MRS is defined then… U i (x  ) p i ———  — U j (x  ) p j  If good i could be zero then…  MRS ji  price ratio  “implicit” price  market price Solution ((same as before)

25. Frank Cowell: Consumer Optimisation The solution…  Solving the FOC, you get a utility-maximising value for each good… July 2015 25 x i * = D i (p, y )  * =  *(p, y )  …for the Lagrange multiplier  …and for the maximised value of utility itself  The indirect utility function is defined as V(p, y) := max U(x) vector of goods prices vector of goods prices money income {  p i x i  y}

26. Frank Cowell: Consumer Optimisation A useful connection July 2015 26  The indirect utility function maps prices and budget into maximal utility  = V(p, y) The indirect utility function works like an "inverse" to the cost function  The cost function maps prices and utility into minimal budget y = C(p,  ) The two solution functions have to be consistent with each other. Two sides of the same coin  Therefore we have:  = V(p, C(p,  )) y = C(p, V(p, y)) Odd-looking identities like these can be useful

27. Frank Cowell: Consumer Optimisation The Indirect Utility Function has some familiar properties…  Non-increasing in every price, decreasing in at least one price  Increasing in income y  quasi-convex in prices p  Homogeneous of degree zero in (p, y)  Roy's Identity July 2015 27 (All of these can be established using the known properties of the cost function) Explanation of Roy’s Identity

28. Frank Cowell: Consumer Optimisation Roy's Identity July 2015 28  = V(p, y) = V ( p, C(p,  )) 0 = V i (p,C(p,  )) + V y (p,C(p,  )) C i (p,  ) 0 = V i (p, y) + V y (p, y) x i *  Use the definition of the optimum  Differentiate w.r.t. p i “function-of-a- function” rule  Use Shephard’s Lemma  Rearrange to get… V i (p, y) x i * = – ———— V y (p, y) V i (p, y) x i * = – ———— V y (p, y) Marginal disutility of price i Marginal utility of money income  So we also have… x i * = –V i (p, y)/V y (p, y) = D i (p, y) Ordinary demand function

29. Frank Cowell: Consumer Optimisation Utility and expenditure July 2015 29 n min  p i x i x i=1 + [  – U(x) ]  Utility maximisation  …and expenditure-minimisation by the consumer  …are effectively two aspects of the same problem  So their solution and response functions are closely connected: x i * = H i (p,  ) C(p,  )  Solution function: V(p, y) x i * = D i (p, y)  Response function:  Problem: PrimalDual n max U(x) + μ [ y –  p i x i ] x i=1

30. Frank Cowell: Consumer Optimisation Summary  A lot of the basic results of the consumer theory can be found without too much hard work  We need two “tricks”: 1. A simple relabelling exercise: cost minimisation is reinterpreted from output targets to utility targets 2. The primal-dual insight: utility maximisation subject to budget is equivalent to cost minimisation subject to utility July 2015 30

31. Frank Cowell: Consumer Optimisation 1. Cost minimisation: two applications July 2015 31  THE FIRM  min cost of inputs  subject to output target  Solution is of the form C(w,q)  THE CONSUMER  min budget  subject to utility target  Solution is of the form C(p,  )

32. Frank Cowell: Consumer Optimisation 2. Consumer: equivalent approaches July 2015 32 PRIMAL max utility subject to budget constraint Solution is a function of (p,y)  DUAL  min budget  subject to utility constraint  Solution is a function of (p,  )

33. Frank Cowell: Consumer Optimisation Basic functional relations July 2015 33 C(p,)C(p,) Hi(p,)Hi(p,)  V(p, y)  D i (p, y) cost (expenditure) Compensated demand for good I indirect utility ordinary demand for input i H is also known as "Hicksian" demand Review Utility money income

34. Frank Cowell: Consumer Optimisation What next?  Examine the response of consumer demand to changes in prices and incomes  Household supply of goods to the market  Develop the concept of consumer welfare July 2015 34